Official Interest Rate Cuts Give Lenders A Chance To Restore Their Margins

The Age

Tuesday September 2, 2008

Steve Keen

Don't expect too much mortgage relief as banks move to regain their health, writes Steve Keen.

LATE last year on SBS News, when Stan Grant asked me which way the Reserve Bank would move rates in 2008, I replied: "Up, and then down". Grant quipped: "Spoken like a true economist - an even-handed answer." To which I replied: "More down than up."

I expected the initial rate rises because of the RBA's focus on the rate of inflation, and a subsequent fall, not because inflation would be heading down, but because the economy would be - and the RBA rate would be forced to follow it.

That day seems upon us, with the "surprise" 1% fall in retail sales, and the first signs of a tapering in credit demand. The RBA is no longer focusing exclusively on inflation, but also on an apparently stalling economy.

All market economists have joined with me in expecting a rate cut this month - despite inflation still being above the RBA's target range.

Until last month's surprise announcement by National Australia Bank, it seemed the only thing that wouldn't be heading down was the mortgage rate. Now it's fairly certain all banks will pass on the RBA cut. But there are good reasons why this is unlikely to be the case for subsequent cuts.

The idea there is some stable relationship between the RBA rate and the mortgage rate is a furphy. When the RBA attempted to manage the economy by trying to control the money supply, the gap between the average mortgage rate and the RBA's overnight rate fluctuated wildly.

After the RBA abandoned targeting the money supply and adopted a policy of trying to control short-term interest rates, a stable relationship of sorts did develop. The gap settled down to about 4percentage points, once the economy recovered from the 1990s recession. This was roughly equal to the historical average gap between the rate banks charge for loans and the rate they offered for deposits - and banks, after all, make their money out of the spread between loan and deposit rates. Interest rate targeting "worked" because it controlled the banks' costs of funds.

The gap between the mortgage and the RBA rate plunged from 4 percentage points in 1994 to 1.8 by mid-1997, because of competition between banks and the new wave of non-bank securitised lenders. It should now be obvious that this was not necessarily a good thing.

Those lower margins were driven primarily by lowering lending standards, rather than efficiencies, or the much-hyped wonders of competition. It therefore stands to reason that the margin will now rise, as the worst excesses of subprime and "low doc" lending are being driven from the market by the credit crunch.

The margin has already risen to 2.35 percentage points, because banks have increased mortgage rates above the RBA's recent rises. But even that margin is short of the 4percentage points gap that applied before lending standards plummeted with deregulation.

The odds are this margin will rise to at least 3 percentage points, and possibly 4, as the RBA is forced to cut rates as the economy falls into recession. So the RBA may have to reduce its rate to 2% to ensure a mortgage rate of no more than 6%.

But the RBA's problem is trivial compared with its US counterparts. US mortgage rates have risen in the past year, even though the Federal Reserve has reduced its rate from 5.25% to 2%. The Federal Reserve has become almost impotent with respect to loan rates - and that impotency has gotten more extreme.

Much the same story applies to corporate borrowers. Aaa corporate bond rates now are the same as when the Federal Reserve rate was

3.5 percentage points higher. The US Fed can do something to restore the profitability of financial institutions by increasing the gap between lending and borrowing rates, but it can do little to take the financial pressure off householders and corporations.

The danger for banks is that their long-term profitability depends not just on the spread between loan and deposit rates, but on borrowers meeting their commitments.

It seems that another casualty of the credit crunch has been the capacity of central banks to manipulate the market interest rate. They can still control short-term rates but have lost their capacity to influence long-term rates. The days of interest rate targeting by central banks may well be over. The Federal Reserve is starting to appreciate this, because official rate moves have done nothing to reduce lending costs - in contrast to Australia's record, where mortgage rates have, until recently, closely tracked official rate movements.

But lenders will start to use some falls in the RBA rate to restore margins between loan and deposit rates. Imprudent lending drove the margin down to unsustainably low levels, and it has to rise to make responsible banking profitable again.

Steve Keen is an associate at the school of economics and finance at the University of Western Sydney.

© 2008 The Age

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